Introduction: Thinking Like an Economist CHAPTER 9 The Theory of Economics…is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions. ―J.M. Keynes The Short-Run Keynesian Policy Model: Demand-Side Policies Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-2 Key Insight of the Keynesian AS/AD Model  Short-run equilibrium output may differ from long-run potential output assuming a fixed price level Equilibrium output is the level of output toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production Potential output is the highest amount of output an economy can sustainably produce using existing production processes and resources  Market forces may not be strong enough to correct deviations from potential output

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-3 Key Insight of the Keynesian AS/AD Model  Paradox of thrift In the long run, saving leads to investment and growth In the short run, saving may lead to a decrease in spending, output, and employment  Aggregate demand management, which is government’s attempt to control the aggregate level of spending, may be necessary  Keynesian economists advocated an activist demand management policy

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-4 US Savings Rates

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-5 The Components of the AS/AD Model Aggregate Demand Curve (AD) Is a curve that shows how a change in the price level will change aggregate expenditures on all goods and services in an economy Short-Run Aggregate Supply Curve (SAS) Is a curve that specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant Long-Run Aggregate Supply Curve (LAS) Is a curve that shows the long-run relationship between output and the price level

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-6 The Slope of the AD Curve The AD curve is downward sloping because of:  Interest rate effect, the effect that a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates  International effect, as the price level falls (assuming the exchange rate does not change), net exports will rise  Money wealth effect, a fall in the price level will make the holders of money richer, so they buy more  Multiplier effect, the amplification of initial changes in expenditures

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-7 The Slope of the AD Curve Price level Real output AD P0P0 P1P1 Y0Y0 Y1Y1 Y2Y2 interest rate, international, and money wealth effects and the multiplier effect The AD curve is downward sloping because of the

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-8 Dynamic Price Level Adjustment Feedback Effects  Dynamic effects exist that can counteract the standard AD shift factors; If strong enough, can cause AD to fall (shift to the left) when the price level falls  Especially important when aggregate demand is declining Expectations of falling aggregate demand Lower asset prices (declining nominal wealth) Financial panics

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-9 Shifts in the AD Curve  A shift in the AD curve means that at every price level, total expenditures have changed. Five important shift factors are: Foreign income Exchange rates Distribution of income Expectations Monetary and fiscal policy  Deliberate shifting of the AD curve is what most policy makers mean by macro policy, or AD management

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-10 Shifts in the AD Curve Price level Real output AD 0 P0P0 AD 1 The AD curve shifts out by more than the initial change in expenditures Initial effect Total effect Exports increase by 100 The multiplier magnifies this shift (assuming multiplier = 3) 300 AD curve shifts to the right by a multiple of 100, in this case by 300 Multiplier effect

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-11 The Aggregate Supply Curves The SAS curve is upward sloping because of:  Auction markets Prices are determined by demand and supply and supply curves are upward sloping (higher P, higher Q)  Posted price markets Also called quantity-adjusting markets, markets in which firms respond to changes in demand by changing production instead of changing their prices Firms tend to increase their markup when demand increases The Slope of the Short-Run Aggregate Supply (SAS) Curve

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-12 Shifts in the SAS Curve  Shifts in the SAS are caused by changes in: Input prices Productivity Import prices Excise and sales taxes  When production costs increase, the SAS curve shifts up  In general: %Δ in price level = %Δ in wages – %Δ in productivity SAS 0 Price level Real output SAS 1 SAS 2

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-13 The Long-Run Aggregate Supply Curve  The long-run aggregate supply (LAS) curve shows the long-run relationship between output and the price level  The position of the LAS curve depends on potential output which is the amount of goods and services an economy can produce when both capital and labor are fully employed  The LAS curve is vertical because potential output is unaffected by the price level

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-14 The LAS Curve Potential output is assumed to be in the middle of a range bounded by high and low levels of potential output LAS Price level Real output Low-level potential output High-level potential output SAS Underutilized resources Overutilized resources A B C When resources are over- utilized (point C), factor prices may be bid up and the SAS shifts up When resources are under- utilized (point A), factor prices may decrease and SAS shifts down

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-15 Shifts in the LAS Curve Increases in the LAS are caused by increases in:  Capital  Resources  Growth-compatible institutions  Technology  Entrepreneurship LAS 0 Price level Real output LAS 1 LAS 2

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-16 Short-Run Equilibrium in the AD/AS Model Short-run equilibrium is where the SAS and AD curves intersect and point E is short-run equilibrium Price level Real output AD 0 P0P0 AD 1 P1P1 Y0Y0 Y1Y1 SAS A shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y 0 to Y 1 and increasing price level from P 0 to P 1 E F

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-17 Short-Run Equilibrium in the AD/AS Model Price level Real output AD P0P0 P2P2 Y0Y0 Y2Y2 SAS 1 A shift up in the short-run aggregate supply curve changes equilibrium from E to G, decreasing output from Y 0 to Y 2 and increasing price level from P 0 to P 2 SAS 0 E G

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-18 Long-Run Equilibrium in the AD/AS Model Long-run equilibrium is where the LAS and AD curves intersect Price level Real output AD 0 P0P0 AD 1 P1P1 YPYP LAS A shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P 0 to P 1 but leaving output unchanged E H

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-19 Application: A Recessionary Gap in the AD/AS Model A recessionary gap is the amount by which equilibrium output is below potential output Price level Real output P0P0 P1P1 YPYP LAS E SAS 0 SAS 1 AD 0 A Y1Y1 At point A, some resources are unemployed and the recessionary gap is Y P – Y 1 Gap Eventually wages and prices decrease and SAS shifts down to return the economy to a long and short-run equilibrium at E

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-20 Application: An Inflationary Gap in the AD/AS Model An inflationary gap is the amount by which equilibrium output is above potential output Price level Real output P0P0 P2P2 YPYP LAS E SAS 0 AD 0 Y2Y2 At point B, resources are being used beyond their potential and the inflationary gap is Y 2 – Y P SAS 2 B Gap Eventually wages and prices increase and SAS shifts to return the economy to a long and short-run equilibrium at E

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-21 Utilizing the AS/AD Model: Aggregate Demand Policy  A primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal policy shifts the AD curve Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economy

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-22 Utilizing the AS/AD Model: Aggregate Demand Policy  Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycle  Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of income

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-23 Application: Expansionary Fiscal Policy in the AD/AS Model If the economy is at point A, there is a recessionary gap equal to Y P – Y 0 The appropriate fiscal policy is to increase government spending and/or decrease taxes AD shifts to the right and output returns to potential output Y P and prices increase to P 1 Price level Real output AD 0 P0P0 AD 1 P1P1 YPYP LAS A E Y0Y0 Gap

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-24 Application: Contractionary Fiscal Policy in the AD/AS Model If the economy is point B, there is an inflationary gap Y 2 – Y P The appropriate fiscal policy is to decrease government spending and/or increase taxes AD shifts to the left, output returns to potential output Y P and inflation is prevented Price level Real output AD 2 P1P1 AD 0 P2P2 YPYP LAS B E Y2Y2 Gap

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-25 Limitations of the AS/AD Model  Feedback effects mentioned earlier  Potential output is difficult to estimate precisely  The economy can become dynamically unstable—a shock can generate changes that are not self-correcting  Implementing fiscal policy through changing taxes and government spending can be a slow legislative process There is no guarantee that government will do what economists say is necessary Automatic stabilizers can avoid this (automatic tax and spending policies that are programmed to occur without additional government action)

19 The Short-Run Keynesian Policy Model: Demand-Side Policies 9-26 Chapter Summary  The key idea of the Keynesian AS/AD model is that in the short run the economy can deviate from potential output  The AS/AD model consists of the aggregate demand curve, and the short-run aggregate supply curve, and the long-run aggregate supply curve  Short-run equilibrium is where the SAS and AD curves intersect; Long-run equilibrium is where the AD and LAS curves intersect  Aggregate demand management policy attempts to influence the level of output in the economy